7.18 Limit on Salary-Reduction Deferrals

Elective deferrals to a 401(k) plan must not exceed the annual tax-free ceiling; otherwise, the plan could be disqualified. If you also participate in a 403(b) tax-sheltered annuity plan (7.21) or simplified employee pension plan established before 1997 (8.16), the limit applies to the total salary reductions for all the plans and any excess deferral should be withdrawn as discussed below. Because of percentage-of-compensation limitations in your employer’s plan, you may be unable to make deferrals up to the annual tax-free ceiling. Also, certain highly compensated employees may be unable to take advantage of the maximum annual tax-free ceiling because of restrictions imposed by nondiscrimination tests.

Both the regular annual deferral limit ($17,000 for 2012) and the “catch-up” contribution limit for those age 50 or older ($5,500 for 2012) are subject to cost-of-living increases; see the e-Supplement at jklasser.com for whether the limits will be increased for 2013.

To avoid the strict nondiscrimination tests for employee elective deferrals and employer matching contributions, an employer may make contributions to a SIMPLE 401(k) (7.17).

An employer may make matching or other contributions, provided the total contribution for the year, including the employee’s pre-tax salary deferral and any employee after-tax contributions, does not exceed the annual limit for defined contribution plans, which for 2012 was the lesser of 100% of compensation or $50,000.

Withdrawing excess deferrals.

A single plan must apply the annual limit on salary deferrals to maintain qualified status. If your deferrals to the plan for a year exceed the annual limit, the excess, plus allocable earnings, must be distributed to you or the plan risks disqualification. If you participated in more than one plan and the deferrals to all of the plans exceeded the limit, you should withdraw the excess, plus the allocable income, from any of the plans, by April 15 of the year following the year of the excess deferral.

Whether the excess deferrals were made to one or several plans, you must report the excess as wages for the year of the deferral on Line 7 of Form 1040. If you withdraw the excess by April 15 of the following year, it is not taxable again when you receive it. However, if the withdrawal of the excess is not received by the April 15 date, the excess is taxed again when received. The withdrawal of allocable earnings is always taxable in the year of the distribution. If a withdrawal of an excess deferral to a salary-reduction SEP (set up before 1997 (8.16)) is not withdrawn by the April 15 date, it is treated as a regular IRA contribution that could be subject to the penalty for excess IRA contributions (8.7).

Excess deferrals (and earnings) distributed by the April 15 date are not subject to the 10% penalty for premature distributions (7.15) even if you are under age 59½.

For the year in which the excess deferral and allocable earnings are distributed to you, the plan will send you a Form 1099-R. Box 7 will include a code designating the year for which the excess is taxable.